Home Equity Loan Vs Home Equity Line of Credit - Which is Right for You

With home values finally recovering from their steep declines of the last half decade, and interest rates still hovering around their historic lows, homeowners are, once again, looking to their home equity for financing. Among all of the factors that go into home equity financing, the first consideration should be the type of financing - a home equity loan (HEL) or a home equity line of credit (HELOC). Both serve the purpose of tapping your home equity, and both offer attractive interest rates; however, they function very differently. Here's how to determine which is right for you.

How are home equity loans different from home equity lines of credit?

A HEL is, essentially, a fixed load with a fixed monthly payment to be paid over a fixed time period - much like your original mortgage except the amount of the loan is based on the amount of equity you have in your home. A typical HEL has a loan period of 10 or 15 years. Because the interest rate is guaranteed, it tends to be a bit higher than the interest rate applied to a HELOC (HELs can also offer an adjustable rate that fluctuates with the prime rate but has a guaranteed ceiling rate).

With a HELOC, a line of credit is established, again, based on the amount of equity in your home. Funds are withdrawn as you need them and you are only charged interest on the borrowed amount. In most cases, the minimum payment on a HELCO can be interest only. The interest rate is usually variable, which means it will rise and decline with the prime rate.

In both cases, the loan amount is established by a loan-to-value formula applied by the lender (typically up to 100 percent) which also considers other factors, such as your income, debt ratios, and your credit history. Also, the interest on both loans may be tax deductible depending on its use and other factors.

Which is right for you?

A HEL may be preferable if you need the funds for a specific, one-time purpose, such as remodeling, a car purchase, or some other lump-sum purchase. The advantage of a HEL is the fixed structure which enables you to keep the financing within your budget and doesn't tempt you with the ability to keep borrowing as you can with a HELOC. The other advantage is, if you choose a fixed interest rate, your interest costs won't increase if interest rates should rise. Financing with a HEL typically involves closing costs which are usually lower than the closing costs on a first mortgage.

A HELOC offers greater flexibility, and, initially, lower interest costs. Common uses of a HELOC are to fund college expenses over time, or an ongoing renovation project. A HELOC can be fully repaid and available for use again if needed. The interest cost for a HELOC is typically lower than that for a HEL, but, because the interest rate is variable, you do assume the risk that interest costs might increase. Although there are usually no closing costs with a HELOC, they often charge an annual fee.

Ultimately, which type of home equity financing is right for you comes down to its purpose, the length of time you'll need the loan, your outlook on interest rates, and your attitude about borrowing. These loans are secured by the equity in your home, so it's important to borrow responsibly and use the funds in a way that can bring a positive return on your finances rather than simply for consumption.